Predicting the Future Direction of the Stock Market

The economic news this past week was that the economy remains in the recovery mode and has not yet gotten to the growth mode. This newsletter will cover the topics of predicting the future direction of the stock market and bank stocks after the weekly recap from Vanguard.

Vanguard

This week's economic reports were variations on a now-familiar theme: notes of growth with melancholy undertones. The Fed's latest report reiterated expectations of a "modest" recovery. The housing market and employment situation remained troublesome. For the week ended October 22, the S&P 500 Index rose 0.6% to 1,183 (for a year-to-date total return—including price change plus dividends—of about 7.8%). The yield of the 10-year U.S. Treasury note ended the week at 2.59% unchanged from last week (for a year-to-date decrease of 126 basis points).

Predicting the Future Direction of the Stock Market

With the economy in a recovery mode what does this mean for the future direction of the stock market? Every investor needs to have indicators that give direction. I use 2 indicators, the Federal Reserve and the Volatility Index. The best indicator for longer term direction is the actions of the Federal Reserve. The best indicator for shorter term direction is the direction and level of the volatility index.

When the Federal Reserve is taking action to grow the economy, like now, this is a positive indicator for the stock market. When the volatility index is dropping and at a low level, like now, this is a positive indicator for the stock market.

This means that now is a good time to buy and hold mutual funds that invest in the stock market.

Bank Stocks

Bank stocks remain in the headlines as the Attorney General for multiple states are investigating issues with issuing and foreclosing of mortgages. News exist that the FBI is now investigating improper behavior. Anytime the words Attorney General or FBI are in a news story it is not good.

For an investor with a short term time horizon this makes bank stocks unsuitable. It is difficult to see how bank stock prices can increase in an environment of legal investigation and potential lawsuits.

For an investor with a longer term time horizon this creates a buying opportunity. Bank stocks are posting better than expected earnings with a reduction in bad loans on the balance sheet and lots of money in reserve thanks to bank stress tests of 1-2 years ago. If you look at the financial picture without this issue these stocks look cheap. Sometime in the future this legal investigation will end and the financial performance of the individual companies will be more important.